More on the Current State of Macro...

“[IMF] Forecasters significantly underestimated the increase in unemployment and the decline in domestic demand associated with fiscal consolidation,” [Olivier] Blanchard and co-author Daniel Leigh, a fund economist, wrote…. Blanchard… writes… that he could not actually determine what multipliers economists at the country level were using …. The number was implicit in their forecasting models…. Heading into a crisis that nearly tore the euro zone apart, in other words, neither Blanchard or any one of the fund’s vast army of technicians thought to reexamine whether important assumptions about the region would still hold true in times of crisis. That, it turns out, was a big mistake. Multipliers vary… get larger if interest rates are low, output is falling and the banking system is creaky – conditions that make everyone, from households to investors, less likely to spend, and thus makes the role of government-generated demand that much more important.

Blanchard and Leigh deduced that IMF forecasters have been using a uniform multiplier of 0.5, when in fact the circumstances of the European economy made the multiplier as much as 1.5, meaning that a $1 government spending cut would cost $1.50 in lost output…

Simon Wren-Lewis:

mainly macro: Macroeconomic Theory and the Multiplier: New Keynesian theory, and therefore the New Neoclassical synthesis, provides pretty clear answers to the multiplier question…. Macroeconomic theory is ‘all over the place’ on many issues, but this is not one of them. I would go further. If policymakers had paid more attention to theory, and less to a well known piece of empirical work [by Alesina and Ardagna], they would have been less likely to have made the mistakes they have. The problem is not ambivalent theory, but the fact that a large section of macroeconomists choose to ignore or discount the relevant theory…

John Quiggin:

The state of macroeconomics: it all went wrong in 1958: [A] good contribution from Robert Gordon… argues that 1978-era New Keynesian macro is better than the DSGE approach…. My own view is even more pessimistic. On balance, I think macroeconomics has gone backwards since the discovery of the Phillips curve in 1958. The subsequent 50+ years has been a history of mistakes, overcorrection and partial countercorrections. To be sure, quite a lot has been learned, but as far as policy is concerned, even more has been forgotten. The result is that lots of economists are now making claims that would have been considered absurd, even by pre-Keynesian economists like Irving Fisher….

The first mistakes in interpreting the result were made by Keynesians…. Although their journal articles included lots of qualifications about expectations effects, these qualifications were downplayed in policy discussions, leading to the idea that… appropriate use of fiscal and monetary policy could permanently reduce unemployment at the cost of somewhat higher inflation… allow “fine tuning” of the economy, in the unfortunate phrasing of Walter Heller…. [T]he “menu” interpretation of the Phillips curve and the belief in fine tuning imparted an inflationary basis to policy….

Friedman’s criticisms were broadly correct, and were validated by the inflationary explosion that began around the time of his address, but he pushed the point too far…. First, at inflation rates near zero, there really is a trade-off, arising from the fact that interest rates can’t be negative. This point was implicit in Keynes’ discussion of the liquidity trap, but was reinforced by Krugman’s analysis of the Japanese experience in the 1990s, and is highly relevant today. Second, he took his critique of the Phillips curve to mean that there was a “natural rate” of unemployment…. It’s turned out that long-periods of high unemployment have their own self-sustaining effects – Olivier Blanchard and Larry Summers christened this “hysteresis”. So, estimates of the natural rate tend to rise when unemployment is high, making the concept virtually useless as a guide to policy.

Third, Friedman used his critique of fine-tuning that macro policy should be confined to a rules-based monetary policy, with no role for fiscal policy. Although Friedman’s own prescription (a rule controlling the rate of growth of the money supply) was unsuccessful and quickly abandoned, these ideas were the basis of the policy regime, based on the use of interest rates as an instrument to meet inflation targets, that prevailed from the 1980s to the financial crisis, and to which central banks plan to return as soon as the crisis is over.

The real decline was in the 1970s and 1980s, as Friedman’s already overstated critique of Keynesianism was pushed to the limits of credibility and beyond….

The main response was New Keynesianism which showed that with plausible tweaks to the standard micro assumptions, some Keynesian results were still valid, at least in the short run…. [T]he pre-crisis consensus consisted of New Keynesians accepting the classical position in the long run, and most of Friedman’s views on short-term macro issues, and abandoning advocacy of fiscal policy, while the New Classicals acquiesced in moderately active short-term monetary policy….

[W]ork done in macroeconomics since the discovery of the Phillips curve has offered an improved understanding of a wide range of issues… [but] has produced and sustained the dominance, in central banks and in much of the economics profession, of an empirically unsupportable position that is resolutely opposed to fiscal stimulus, or to any large-scale countercyclical policy… diverted most of the intellectual energy of academic macroeconomists into a largely fruitless search for microfoundations at the expense of an improved understanding of the various co-ordination failures…

Comments

“[IMF] Forecasters significantly underestimated the increase in unemployment and the decline in domestic demand associated with fiscal consolidation,” [Olivier] Blanchard and co-author Daniel Leigh, a fund economist, wrote…. Blanchard… writes… that he could not actually determine what multipliers economists at the country level were using …. The number was implicit in their forecasting models…. Heading into a crisis that nearly tore the euro zone apart, in other words, neither Blanchard or any one of the fund’s vast army of technicians thought to reexamine whether important assumptions about the region would still hold true in times of crisis. That, it turns out, was a big mistake. Multipliers vary… get larger if interest rates are low, output is falling and the banking system is creaky – conditions that make everyone, from households to investors, less likely to spend, and thus makes the role of government-generated demand that much more important.

Blanchard and Leigh deduced that IMF forecasters have been using a uniform multiplier of 0.5, when in fact the circumstances of the European economy made the multiplier as much as 1.5, meaning that a $1 government spending cut would cost $1.50 in lost output…